Income Inequality, International Payments Imbalances, and Crises

Robert Wade argues that national income inequality and international payments imbalances played a significant role in the financial crisis, and if these issues are not addressed, the problems are likely to reoccur:

I agree with and admire the lucidity of Jeff Madrick’s post… But … the focus on [microeconomic] financial regulation obscures the important role of “external” causes in contributing to financial instability (external to national financial systems), and obscures the pressing need for policy reforms to curb these external causes. I highlight two external causes: (1) national income inequality; and (2) international payments imbalances. I argue that if high income inequality and large international payments imbalances are not curbed,… microeconomic efforts to re-regulate and re-structure national financial systems will be eroded or swamped by the force of these more macroeconomic external causes.

On the role of income inequality, in the United States between 1976 and 2007 the top 1% of income recipients received almost 60% of … real income growth. The figure is even more stunning if one takes just the 2000s: the top 1% received more than 70% of the total increase. On the other hand, through the 1990s and 2000s incomes in the bottom half of the American income distribution have stagnated.

One channel by which this soaring inequality contributed to financial instability is reasonably well known. The great bulk of the population on stagnant or near-stagnant incomes tried to increase their consumption and investment by borrowing. With easy access to credit they provided a rising demand for non-prime mortgages, car loans and the like. Their demand pushed up house prices, which enabled them to borrow against the rising value of their houses – to reach levels of debt completely unsustainable … in the event that house prices stopped rising. …

The other channel has received less attention, and it relates to the direct effect of the concentration of income and wealth at the very top. People at the top – high net worth individuals, investment funds, pension funds and the like – greatly increased the demand for complex financial products as they searched for ways to store their wealth. The proliferating billionaires around the world pressured organizations like Goldman Sachs and JP Morgan to supply them with complex financial securities. The investment banks generated huge fee and commission revenues by obliging, and neoliberal economic principles allowed the regulators to believe that the surging growth of complex financial instruments must be to the social benefit.

As long as this external pressure to supply complex financial securities for the super-rich to store their wealth continues, the financial system will remain prone to generate bubbles, followed by crashes. We know that modern capitalism can flourish with a much more equal distribution of income and wealth than in the United States, Britain and many other OECD countries. Reformers should use this argument to press for globally coordinated policy action to close down tax havens (to prevent tax avoidance), and to make the tax burden progressive rather than regressive, as it now tends to be, including capital gains.

The second deep external cause of financial instability is global payments imbalances. The key point is that the present system of international financial transactions … tends to make finance the “master” and the real sector its “servant”… This relationship is a key driver of financial crises, and the key policy question is how to make the real sector the master and the financial sector its servant.

For example, Iceland (from where I write) over the 2000s had a floating exchange rate and unrestricted capital inflows. The result was something which the economics textbooks said should not happen:… huge trade deficits and at the same time the krona appreciated in value… According to the textbooks, the krona should have depreciated, so that … the trade deficit would go down. But it did not. The government allowed free inflows of capital, and capital surged in to take advantage of Iceland’s high interest rates compared to rates in Japan, Switzerland and elsewhere (the central bank set high interest rates to try to curb the inflationary pressure caused by the money inflow). The inflow of capital pushed up the value of the krona, and the government assured the people – quite wrongly — that the high value of the krona reflected international confidence in Iceland, including in its banks.

In our present international financial system a country can be flooded with capital inflows (like Iceland), and must then let its currency appreciate or (if the exchange rate is fixed) suffer inflation; or both. Either way the trade deficit will worsen as exports fall and imports increase. Hence capital flows become the master and the trade flows become the servant, rather than the other way around. The toxic effect is to make many economies around the world vulnerable to a sudden withdrawal of capital, as happened in East Asia in 1997-98 and in Iceland, the Baltics and east and central Europe in 2008-09.

Without reforms to curb both these causes of financial instability we will likely experience further serious crises over the next decade. The sheer magnitude of the demand for complex securities in which the swelling ranks of the super-rich can store their wealth will swamp efforts to keep banks within prudential limits; as also will the sheer magnitude of cross-border capital flows (which are also a function of high income and wealth inequality at the top). … The question is how progressive forces can exercise countervailing pressure, and what policy and structural changes they should advocate. Progressive tax reform and restrictions on capital flows in unstable times (and at least blue sky discussion of how a mechanism of coordinating exchange rate changes might be established) should be high on the agenda.

Originally published at Economist’s View and reproduced here with the author’s permission.

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